American Butter Institute Market Situation & Outlook

Fourth Quarter 1998
Volume 1, Number 4

Editor: Chris A. Nubern

With the end of the holiday season, the butter industry experienced the conclusion of one of the most volatile years in the history of the industry. Although this statement is certainly true in terms of price, 1998 will also be remembered for the emotional debates on butter imports, daily cash trading, and futures market development. Because some of these issues were not resolved in 1998, the butter industry should prepare for another interesting year. Some of the issues that will require immediate attention from the industry include daily trading at the Chicago Mercantile Exchange (CME) and the development of a new milkfat market. The potential effects from these market adjustments are examined in this ABI Market Situation & Outlook.

Also included in this report is a brief review of market performance in 1998. Given the industry's record setting pace, a final year-end-review is warranted. This analysis includes a discussion of potential marketing conditions that may affect the industry in 1999 - including projections for butter production and market prices.

1998 Year-End-Review

Strong demand and short supplies resulted in record high butter prices in 1998. With the exception of three weeks during the holiday season of 1997, weekly butter prices for 1998 surpassed the corresponding weekly market prices established during the past two years (Figure 1). Never before has the strength of the markets lasted for such an extended period of time.

Figure 1

The average Grade AA price at the CME market for 1998 was $1.778 - 53% higher than 1997's average price of $1.161. Throughout the year, Grade AA butter prices ranged from a low of $1.14 per pound in mid January to a record high of $2.81 in mid September. On one frantic day of trading in September, a load of butter actually sold for $2.95 per pound. Although this sale did not set the market price for the day, transactions at this price level serve notice as to how tight the market actually was during the fall months.

Trading activity at the CME cash market also increased substantially for 1998. Throughout the year, a total of 618 carlots of Grade AA butter were traded on the CME market. This represents a 22% increase when compared with the 1997 trading level of 506 carlots. Monthly sales transactions ranged from a low of 11 carlots in January to a high of 115 carlots in November. On average, 52 loads were sold each month. This compares to a monthly average of 42 carlots in 1997 and 10 carlots in 1996. Although activity in the cash market is increasing at a good pace, estimates show that total sales transactions in 1998 will represent only about 2.5% of total butter production.

More active markets and record high prices are the direct result of limited butter supplies throughout 1998. Factors such as low milk production, declining butter stocks, and strong demand for butter, ice cream, and other milkfat products caused the short supply of butter. From 1992 to 1997, U.S. butter production has declined about 16% from a high 1,365 million pounds. Preliminary estimates for 1998 show butter production at about 1,062 million pounds - an 8% decline compared to 1997. Because of extreme weather conditions, milk production for 1998 recorded only marginal increases - thus limiting annual growth in the total supply of milkfat. The limited milkfat supplies available to the market were often utilized first to satisfy the growing demand in higher-valued markets like ice cream and cream cheese. As is often the case, the demand for butter was treated as a secondary market and was not adequately supplied with milkfat. To satisfy the needs of a growing demand base, butter manufacturers had to confront competitors in a free market arena that, according to some buyers, rivaled the ancient era of Roman gladiators.

Unlike previous years, commercial and government stocks of butter were not able to provide the market with a buffer that could be used to carry the industry through the seasonal demands of the summer and fall months. For example, butter stocks in May 1998 were estimated at 72.7 million pounds - or about 30% less than May 1997. Unfortunately, many casual observers may conclude that lower butter stocks in 1998 were related to subsidized exports of butterfat. In fact, from January through March, butter stocks in 1998 surpassed those of 1997 by an average 8.2 million pounds. Because estimates show that the majority of subsidized exports occurred from June 1997 to February 1998, it is unlikely that export activity created the critical shortage of butter in 1998. These observations are an indication that the lower stocks of butter are likely associated with far more complex issues - possibly butter pricing and the residual allocation of milkfat.

Increased imports of butter and butter substitutes in the fall of 1998 helped provide some relief from the supply crisis. For October and November, total butter stocks are averaging about 8.9 million pounds higher than 1997 levels. Depending on December sales activity, the industry could be starting out 1999 with stock levels that are comparable with 1996 and 1997, but about 30% lower than January 1998.

What to Expect in 1999

—Butter Production: The key to having a relatively stable year in the butter markets will depend on the supply situation. With current production levels of 1,062 million pounds, very little product is being left on the shelf or in the warehouses at the end of the year. Given the strong demand for butter, additional supply is the only variable that will keep butter markets from setting new records in 1999. Currently, economic models predict that the supply of butter will increase about 3% in 1999 for a total of 1,088 million pounds. Although these results are considered somewhat high, other industry analysts do agree that butter production will rebound in 1999 from its seven-year decline. Currently, production estimates are ranging from a one percent decline to a three percent increase relative to 1998. From a statistical perspective, the difference of four percentage points is insignificant. Compared to an average production decline of 5.6% since 1996, the industry should view current 1999 production estimates as a possible turning point.

—Market Prices: Increases in U.S. milk production are going to lead to a larger supply of milkfat in 1999. Some of the additional supplies will likely be allocated to the butter markets. Because the butter industry would like to avoid a repeat of 1998, risk management will largely consist of inventory management. Stocks of butter are expected to grow at a moderate pace during the surplus months. With higher inventories and increased production, wholesale butter prices at the cash market are currently not expected to rise above $2. A general concensus among industry analysts is that market prices will range from $1.15 to $1.90 with a annual average for Grade AA of about $1.50 per pound.

—Daily Trading: In 1998, the butter industry learned to function without Grade A and B market prices. Additional adjustments for this year are on the horizon. One of the industry's first challenges of 1999 will involve adjusting to multiple trading days at the CME. Unless unforeseen events develop, the cash market at the CME will most likely begin trading butter three days a week beginning sometime in late February or early March. Given the current pricing system used by the industry, the additional pricing information is likely to result in some difficulties for butter manufactures. Currently, there are no immediate solutions to the challenges facing the industry. To remain competitive with additional pricing information, long-term improvements are needed in the areas of (1) legally binding contracts between buyers and sellers, (2) viable futures contracts, and (3) efficient pricing of milkfat.

—Price Discovery for Milkfat: People in the industry are concerned about using butter prices as the basis for establishing the value of cream. Although the market value of butter and cream will always be highly correlated, additional pricing information from other products is not being adequately incorporated into the current pricing system. Butter, like ice cream and cream cheese, is just one product out of many that utilize milkfat as a primary input. Determining the value of cream solely on the basis of butter prices is a reckless disregard of pricing information in other product markets - especially when the other products are utilizing an increasing share of the supply of milkfat.

Although the current pricing structure may have been appropriate in the past, structural changes in the milkfat market warrant a new pricing mechanism. A possible solution is the development of a milkfat market. With this new mechanism, pricing information from all market outlets, not just butter, will be used to determine the fair market value of cream. Although butter prices would remain one of the driving forces in a milkfat market, the new market would at least provide the appropriate forum to incorporate additonal information from other product markets. The development of a milkfat market will not happen overnight. There are many technical issues that remain unresolved at this time. Even so, the members of ABI should remain optimistic and continue working toward the successful development of this market with the CME.